An extremist, not a fanatic

January 25, 2013

Remember animal spirits?

There's one reaction to the UK's lack of meaningful economic recovery that is surprisingly absent.

To see it, remember that a big reason for our slow growth is a lack of capital spending; the volume of business investment, though up from its 2009 low-point, is still 11.6% below its 2007Q4 peak.

But why is capital spending so weak? There are lots of possibilities: the slowdown in technical progress has created a dearth of investment opportunities; fears that banks will restrict future credit lines are causing firms to hoard cash; falling real wages are encouraging labour-capital substitution; and spare capacity and weak demand mean there's little need to expand.

I don't want to reject any of these. But there's another possibility, raised in a new paper by Charles Lee and Salman Arif - that investment and the recovery are held back by depressed animal spirits.

They point out that business investment is well correlated with investors' sentiment towards shares. My chart shows that a similar thing is true in the UK. We can measure sentiment by the ratio of Aim stocks to the FTSE 100; Aim shares tend to be smaller, less well-known and more speculative than bigger shares, and so high prices for them are a sign of high spirits. You can see that this ratio has tended to predict business investment, with a lag - the lag being because it takes time for investment decisions to translate into actual spending.

Of course, a correlation between investor sentiment and capital spending might exist simply because rational expectations of the future determine both. If so, then current weak sentiment and weak investment are a sign of weak future growth.

But Lee and Arif's work suggests this might not be so. They estimate that, in most advanced countries, high investment leads to weaker GDP growth and falling profits. That's exactly the opposite of what you'd expect if sentiment and investment were rationally determined.

This leaves us with another possibility - that it is irrational animal spirits that drive sentiment and capital spending. And herein lies the point that is not widely made. It's that the economy is being depressed in part by company bosses being irrationally pessimistic. We're paying the price for stupidity in boardrooms.

Such a reaction should appeal to both Keynesians - who coined the phrase "animal spirits"? - and to government supporters wanting to deflect blame from Osborne.

And yet it is rarely heard.I suspect one reason for this lies in the power of managerialist ideology. Whilst the ruling class are quick to attribute irrationality to ordinary people, they are blind to the possibility that irrationality can also be found at the top of hierarchies.

De Long and Summers have published a paper setting out the conditions under which fiscal expansion could be self financing.

I wonder under what conditions an increase in investment might be? Here's what I have in mind: of course an investment boom would boost the economy whilst in progress, but whilst investment creates future productive capacity, it doesn't necessarily mean that capacity is going to be utilised. In some cases it becomes clear that those investments are not going to make returns, loans turn bad and things go pear shaped. People continually predict this kind of outcome in China, for example.

Now, if investment were to increase because there was some external reason to expect increased future demand for higher productive capacity, this question is beside the point. But if there was some exogenous-ish increase in investment - perhaps because animal spirits improve - I wonder under what circumstances this would lead to a self-fulfilling happy future, and under what circumstances it would merely sow the seeds of a future slump.

What about that investment has been depressed for decades because it has been been vastly more profitable (especially after tax) to "invest" in capital gains on real estate financed by exporting oil and debt?

Given the fabulous rate of returns for the past 25 given by those, why should anyone be a sucker and invest in anything remotely productive?

And given the uncertain situation, why should anyone invest in anything productive in the UK rather than exporting capital to some offshore safe haven?

The relationship in that AIM/FTSE ratio and investment is not clearly represented in that chart at all to my mind. Look at eh amssive collapse and V shaped recovery in the AIM/FTSE ratio circa 99-2000... where was that reflected in investment?
Couldn't 'somewhat' rational reasons 'not' to invest due to perceived lack of profit potential [which is the marxist case, with rate of profit still below the levels of the pre crisis period]be at the root of low investment whilst animal spirits per se seem more relevant near the ends of such 'investment' 'disinvestment' cycles when sheep mentality rules. With continued public divestment/spending cuts still on the cards and our main export markets stagnating at best, it seems entirely rational to hold fire on major capital outlays for the time being. Which does reinforce the idea that state led investment is precisely what we should be aiming for right now.

«Couldn't 'somewhat' rational reasons 'not' to invest due to perceived lack of profit potential be at the root of low investment»

This debate has a ridiculous aspect, talk of "low investment" as if investment overall had decreased.

But investment across all asset classes has continued to increase.

Obviously the implicit qualification is "productive investment in the UK", but this is a very big and arbitrary qualification.

In any case case it is impossible to understand the amount of productive investment in the UK without considering the alternative asset classes, that is speculative investment in the UK or productive investment outside the UK, and those have been doing very very well for decades...

More in general perhaps I should take the occasion to note that most of my comments are based on astonishments and disappointment that so many arguments are based on "business as usual", textbook assumptions straight out of the direst neoclassical fantasy models, and most about a closed economy spontaneously returning to equilibrium.

The past 25 years especially in the UK have been an amazing ride, a totally business-not-as-usual situation, the the UK becoming briefly an oil exporter with a variant of the Dutch disease, a real estate bubble of astounding proportions, extreme economic dislocation, immense shifts in politics, and a very changed international background.

Ignoring history and the wider context to bemoan the reduced level of business investment in the UK sounds rather implausible to me, even if the "animal spirits" story is interesting.